Why digital music companies and the labels have so much trouble getting along

YouTube and Sony Music Entertainment (NYSE: SNE) reached an agreement last week on a music-sharing deal, providing a welcome break from the nasty back and forth between Warner Music and the video behemoth over their collapsed deal. The Sony/YouTube agreement will provide music videos for all to see and presumably will make money for both parties. So why aren't the labels and digital startups (not just YouTube, but others as well) inking more deals? The answer lies in how the deals are usually structured and the way that the two sides approach the negotiating table. (I know a little bit about this subject, having founded a music company and been involved in negotiating sessions over the same types of rights.)

First, the details of the deals, which for the past few years have consisted of the following terms:

• The digital company makes large upfront payments to the label (aka advances) - millions of dollars in the case of a company the size of YouTube - that are recouped as revenue from ads sold on the streams.

• The record label receives a penny for every stream whether or not advertising is sold on the content. Recently I've heard that this has fallen to an eighth of a cent because of the economy.

• If advertising is sold on the content, the two parties split the revenue 50/50 after the original penny a stream is paid to the label.

To understand the implications of these terms for closing deals, consider the penny-per-stream component. It amounts to $10 per 1,000 streams, or a $10 clicks-per-thousand. This means that before the digital company makes any money on advertising it would have to pay the first $10 of the ultimate CPM to the labels, then split what's left 50/50. So, if YouTube were to sell a $20 CPM pre-roll on a music video, it would give the first $10 to the label then keep $5 of the remaining money. That's $15 to the label and $5 to YouTube, or an effective CPM of $5 on a pre-roll ad. That's not going to leave YouTube rolling in revenue, never mind profits. Throw in the fact that it has to pay millions of dollars upfront, and you can see why these talks are so strained.

Then, there is the mindset of each side in the negotiations.

Record labels point to their past negotiations with Apple (NSDQ: AAPL) as a mistake they don't want to make again. When Steve Jobs created iTunes he forced the labels to sell their music one song at a time, compensating the labels with 70% of the revenue. Seems reasonable, but, as many people know, Apple stock soared to new heights, while label stocks tanked amid the tidal wave of digital music and piracy. This time the labels are making sure they get paid more handsomely. Also driving the labels' negotiating position is that they put a lot of resources into their artists - and take sizable risks on them - but just one in 10 succeed. So they expect guaranteed payments, and healthy returns, from the digital deals on the artists who do succeed. Otherwise, digital companies could simply sit back and cherry pick the best artists at great prices, monetizing their business while labels take all the development risk.

Digital companies, meanwhile, believe the labels kill dynamic businesses through greed and a lack of sophistication. On his company's earnings call last week, Real Networks chief executive Rob Glaser blamed them for "stifling innovation." Jason Herskowitz of the recently shuttered Total Music, a mobile music site funded by the labels, had this to say on his blog last week: "All of the famished participants have to sit at the table - and be content to let all the others have a little bit to eat, even though they are still hungry themselves."

YouTube will probably reach deals with at least two other labels (Warner remains a question mark). But more broadly, the labels and digital startups don't seem to know how to get along. Meanwhile, each side is considering alternative business models that don't depend on the other for success. Digital businesses like YouTube are focusing more on original programming and webisodes rather than music videos, even though music videos remain the most-watched content on the site. Record labels have been discussing creating their own 'Hulu-Style' online video site, but have themselves been involved in difficult negotiations about how to divvy up that pie.

Explaining why these talks are so tortured is one thing - finding a solution that satisfies both parties is another. But there are things that each side could do to break this logjam. In a follow-up piece next week, I'll explore some of them.